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THE 

FIXED  "RATE  OF  RETURN" 
ON  UTILITIES 


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HENRY  I.  LEA 
CONSULTING  GAS  ENGINEER 

PEOPLES  GAS  BUILDING 

CHICAGO 


INTRODUCTION 

One  of  the  most  vital  points  in  the  regulation  of 
utilities  by  state  commissions  is  found  in  the  rate  of 
return  allowed. 

The  fixed  rate  of  return  does  not  meet  requirements. 

It  is  believed  that  the  variable  rate  of  return,  as 
herein  suggested,  will  be  found  not  only  equitable  but 
capable  of  yielding  to  the  communities  served  and  to 
the  utilities  themselves,  the  maximum  of  benefit. 

The  advantages  to  community  and  to  utility  are 
mutual. 

Henry  I.  Lea. 


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(Article  Reprinted  from  the  11/25/14  Issue  of\ 
"The  Gas  Record"— Chicago      / 


THE  FIXED  "RATE  OF  RETURN" 
ON  UTILITIES 

This  Serious  Error  of  Present  Commission 
Regulation  is  shown  to  be  Against  the  Best 
Interests  of  All  Concerned  and  a  Practic- 
able Solution  of  the  Difficulty  is  Suggested 

By  Henry  I.  Lea 

A  uniform  wage  among  men  has  been  shown  to  result 
in  the  over-payment  of  many  men,  the  under-payment 
of  a  smaller  number,  and  the  stifling  of  ambition  and 
effort  in  many  of  those  most  capable  of  development. 

I  presume  it  is  safe  to  say  that  none  of  the  leaders 
in  any  line  of  effort  has  been  developed  except  through 
the  hope  of  attaining  a  position  considered  in  some  way 
more  attractive  than  that  of  the  average  man. 

There  must  have  been  in  each  of  such  cases  a  constant 
incentive  to  greater  and  more  efficient  effort. 

Even  those  men  who  have  become  leaders  may  be 
seen  to  relax  when,  through  conditions  beyond  their 
control,  the  abilities  of  such  men  along  proper  chan- 
nels are  no  longer  fairly  rewarded. 

All  of  this  is  so  well  known  that  it  would  hardly  be 
worth  repeating  here  were  it  not  for  the  fact  that  it  has 
apparently  been  overlooked  in  the  regulations  of  some 
of  our  public  utility  commissions. 

The  results  from  the  operation  of  any  public  utility 
are,  of  course,  very  largely  determined  by  the  attitude 
of  the  individuals  operating  that  utility;  and,  if  those 


individuals  do  not  have  before  them  a  continuous  in- 
centive to  greater  and  more  efficient  effort,  it  is  obvious 
that  the  community  must  suffer. 

In  all  lines  of  bargaining  between  man  and  man,  it  is 
accepted  as  proper  and  right  that  the  seller  shall  be 
entitled  to  a  larger  profit  if  by  any  proper  device  he  can 
give  to  the  buyer  a  larger  value  for  the  unit  price. 

Recognition  of  this  principle  is  certainly  one  of  the 
most  potent  causes  of  our  present  industrial  develop- 
ment. 

Such  dealings  as  are  fair  and  right  between  man  and 
man  should  be  fair  and  right  between  the  public 
utility  and  the  community  served;  yet  the  public  utility 
commissions  of  several  of  our  states  have  seen  fit  to 
place  arbitrary  limits  upon  the  earning  capacities  of  the 
utilities  in  such  manner  as  to  injure  not  only  the  util- 
ities but  also  (and  in  greater  degree)  the  communities 
served. 

There  is  no  valid  objection  to  the  control  by  com- 
missions of  the  rates  (and  through  the  rates,  the  earn- 
ing capacities)  of  public  utilities,  provided  such  regula- 
tion be  brought  about  in  such  manner  as  to  be  of 
greatest  benefit  to  all  concerned. 

It  is  impossible  to  realize  the  greatest  benefit  to  all 
concerned  if  the  utility  is  restricted  in  its  earning  capac- 
ity to  a  fixed  percentage  of  its  rate-making  value,  because 
when  a  given  utility  has  reached  the  maximum  earnings 
allowable  under  such  regulation,  the  men  responsible 
for  its  operation  will  naturally  relax  their  efforts  toward 


greater  economies  of  operation  and  greater  volume  of 
sales  and  further  reductions  in  selling  price  of  the 
product. 

The  interests  of  the  community  served  can  be  best 
protected  by  holding  before  the  management  of  the 
utility  a  continuous  incentive  to  further  effort. 

Such  incentive  is  not  provided  by  the  type  of  rulings 
made  to  date  by  public  utility  commissions  in  the  mat- 
ter of  rate  of  return. 

The  rate  of  return  should  not  be  fixed  at  a  given  per- 
centage of  the  rate-making  value,  but  should  be  variable 
and  largely  determined  by  the  efficiency  of  the  manage- 
ment as  viewed  from  the  standpoint  of  the  community 
served. 

In  other  words,  if  a  given  utility  can,  by  any  proper 
device,  bring  about  a  reduction  in  the  average  selling 
price  of  its  product,  such  utility  should  be  allowed  a 
relatively  larger  rate  of  return  than  considered  proper 
under  the  higher  selling  price  of  its  product. 

Let  us  assume  that  two  given  cities  have  the  same 
population  and  the  same  characteristics  (in  so  far  as 
the  cost  of  gas-plant  construction  and  of  gas  manu- 
facture and  distribution  are  concerned)  and  that  these 
two  cities  are  supplied  by  separate  companies,  each 
selling  gas  at  a  dollar  per  thousand  and  each  having  the 
same  volume  of  sales. 

If,  through  the  coming  years,  the  first  of  these  gas 
companies  continues  selling  gas  at  a  dollar  per  thousand 
cubic    feet,    while    the    second    plant,    through    more 


efficient  management,  succeeds  in  increasing  its  sales 
or  in  reducing  its  operating  expenses  (or  both)  to  such 
extent  as  to  allow  of  a  reduction  in  the  average  selling 
price  per  thousand  cubic  feet,  it  is  obvious  that  the  rate 
of  return  allowed  to  the  second  company  (other  things 
being  equal)  should  be  greater  than  that  allowed  the 
first  company,  because  the  second  company,  through  its 
reduction  in  the  average  price  of  gas,  will  have  effected 
for  the  community  a  distinct  and  measurable  saving. 

As  between  man  and  man,  there  should  be  no  ques- 
tion as  to  the  propriety  of  allowing  a  higher  rate  of 
return  in  the  second  instance  than  in  the  first. 

No  community  will  receive  its  maximum  benefit 
from  the  use  of  gas  until  the  sales  in  that  community 
are  at  a  maximum. 

Such  maximum  sales  will  not  be  obtained  until  the 
schedule  of  rates  adopted  places  gas  in  a  strong  com- 
petitive position  throughout  its  entire  range  of  pos- 
sible use. 

As  the  maximum  earnings  of  the  gas  company  cannot 
be  reached  except  through  maximum  sales  of  its  prod- 
uct, it  is  clear  that  the  interests  of  the  community  and 
the  interests  of  the  gas  company  are  very  largely  iden- 
tical; it  is  also  clear  that  such  maximum  benefits  to 
the  community  as  well  as  to  the  company  will  never  be 
obtained  except  through  the  active  co-operation  of  all 
concerned. 

It  is  unfair  to  demand  and  illogical  to  expect  relative- 
ly increased  benefits  for  the  community  through  use  of 


the  product  of  the  utility,  without  relatively  increased 
reward  to  the  utility. 

As  previously  indicated,  the  rate  of  increase  in  reward 
to  the  utility  should  be  determined  by  its  rate  of  in- 
crease in  efficiency  as  viewed  from  the  standpoint  of 
the  community. 

In  the  tabulation  accompanying  these  notes,  I  have 
shown  a  specific  method  of  measuring  such  efficiency. 

In  preparing  this  tabulation  it  is  assumed  that  a  rate- 
making  body  shall  have  examined,  in  the  year  191 5,  a 
gas  property  having,  at  the  beginning  of  that  year,  a 
rate-making  value  of  $10,000,000. 

It  is  also  assumed  that  during  that  year  this  company 
shall  have  sold  2,000,000  M  cubic  feet  of  gas,  and  that 
the  average  net  revenue  received  from  such  sales  shall 
have  been  $1.00  per  thousand  cubic  feet  sold,  yielding 
a  net  total  revenue  for  the  year  of  $2,000,000. 

It  is  also  assumed  that  for  that  year  this  company 
shall  have  had  operating  expense  (exclusive  of  bond 
interest  and  dividends)  of  65c  per  thousand  cubic  feet 
sold,  or  a  total  operating  expense  for  the  year  of 
$1,300,000.  This  would  leave,  for  bond  interest  and 
dividends,  35c  per  thousand  cubic  feet  sold,  or  a  total 
of  $700,000. 

It  is  also  assumed  that  to  the  rate-making  value  at 
the  beginning  of  191 5  there  shall  have  been  added 
$909,000  during  the  year.  The  amount  of  $700,000 
available  for  bond  interest  and  dividends  during  191 5 
would  therefore  represent  6.69%  on  the  average  rate- 


TABLE  SHOWING  RELATIVE  IMPORT  A 
OF  OPERATION  UNDER  V: 

1915  IQl6  1917  1918 

Rate-making  value  at  beginning  of  year  $10,000,000    $10,909,000    $11,869,000  $12,881,000 

Additions  to  same  during  year 909,000 960,000        1,012,000      1,065,000 

Gas  sold  during   year    (thousand  cubic 

feet) 2,000,000        2,200,000        2,420,000      2,662,000 

Increase  over  sales  of  previous  year 10% 10% 10% 10% 

Average  net  revenue  per  thousand  cubic 

feet  sold $1.00  $  .985  $  .970  $  .955 

Total  net  revenue  per  year $2,000,000      $2,167,000    $  2,347,400    $2,542,210 

Operating   expense    (exclusive    of   bond 

interest  and  dividends)  per  thousand 

cubic  feet  sold $  .65  $  .632  $  .614  $  .596 

Total    operating   expense    (exclusive    of 

bond  interest  and  dividends) $1,300,000      $1,390,400      $1,485,880    $1,586,552 

Available  for  bond  interest  and  dividends 

per  thousand  cubic  feet  sold $  .35  $  .353  $  .356  $  .359 

Total   available   for   bond   interest   and 

dividends  (  =  net  earnings) $700,000         $776,600  #861,520        $955,658 

Rate  of  return  on  average  rate-making 

value  throughout  year 6.69%  6.8i%  6.96%  7-12% 

Net  earnings  required  to  yield  6.69%  on 

average  rate-making  value  through- 
out year $700,000         $761,924         $827,888       $897,363 

Actual  net  earnings  in  excess  of  6.69% 

return o  $14,676  $33,632         $58,29$ 

Minimum  actual  saving  to  community 
through  reduction  in  average  price  of 
gas: 

On  volume  sold  during  1915 o 

On  increase  during  1916 

"       1917 

"       1918 

"  1919 

"  1920 

"  1921 

"  1922 

"  1923 

"  1924 

Total 


Minimum  actual  saving  to  community  in 
percentage  of  t 
munity  for  gas 


percentage  of  total  payment  by  com- 
fo 


$30,000 
0 

$60,000 

3,000 
0 

$90,000 

6,000 

3,300 

0 

*  ..... 

$30,000 

$63,000 

.  $99,300 

1.38% 

2.68% 

3-90% 

fe  to  community  and  to  company 
Viable  rate  of  return 


1919 

1920 

1921 

1922 

1923 

1924 

1925 

1  #13,946,000 
1,118,000 

$15,064,000 

1,171,000 

$16,235,000 
1,224,000 

£17,459,000 
1,276,000 

$18,735,000 
1,325,000 

$20,060,000 
1,372,000 

$21,432,000 
1,415,000 

2,928,200 
10% 

3,221,020 

10% 

3,543,122 
10% 

3,897,434 

10% 

4,287,177 
10% 

4,715,894 

10% 

5,187,483 
10% 

£  .94 

$2,752,508 

i  .925 
$2,979,444 

$  .91 
$3,224,241 

£  .895 

$3,488,203 

$  .88 
$3,772,716 

$  .865 
$4,079,248 

$  .85 
$4,409,360 

$  .578  $  .560  $  .542  $  .524:  $  .506  $  .488  $  .47 

$1,692,500  $1,803,771  $1,920,372  $2,042,255  $2,169,312  $2,301,356  $2,438,117 

$  .362  $  .365  $  .368  $  .371  $  .374  $  .377  $  .38 

$1,060,008  $1,175,672  $1,303,869  $1,445,948  $1,603,404  $1,777,892  $1,971,243 

7.30%  7-51%  7-71%  7-98%  8.26%  8.56%  8.90% 

$971,054  $1,046,952  $1,127,064  $1,210,689  £i,297,693  £1,387,907  $1,481,133 

,954  $128,720  $176,805  $235,259  $305,7"  $389,985  £490, 1 10 


$120,000 

$150,000 

$180,000 

$210,000 

$240,000 

£270,000 

£300,000 

9,000 

12,000 

15,000 

18,000 

21,000 

24,000 

27,000 

6,600 

9,900 

13,200 

16,500 

19,800 

23,100 

26,400 

3,630 

7,260 

10,890 

14,520 

18,150 

21,780 

25,410 

0 

3,993 

7,986 

n,979 

15,972 

19,965 

23,958 

0 

4,392 

8,784 

13,176 

17,568 

21,961 

0 

4,832 

9,663 

14,494 

19,326 

0 

5,315 
0 

10,629 

5,846 
0 

15,944 
11,692 

6,431 

£139,230 

£183,153 

$231,468 

$284,615 

£343,076 

£407,382 

$478,122 

5.05% 

6.14% 

7.17% 

8-15% 

9-09% 

9.98% 

10.84% 

making  value  of  this  property  throughout  the  year. 

It  is  also  assumed  that  the  public  utility  commission 
(or  other  rate-making  body)  shall  have  determined  that 
6.69%  is  a  fair  rate  of  return  for  this  property  under  the 
conditions  found  in  191 5. 

Now,  my  suggestion  is  that,  instead  of  maintaining 
this  same  6.69%  on  the  then  rate-making  value  as  con- 
stituting a  fair  rate  of  return  through  each  of  the  years 
to  follow,  the  rate  of  return  allowable  to  the  company 
shall  be  increased  from  year  to  year  by  an  amount  in 
money  not  exceeding  the  saving  effected  for  the  com- 
munity during  such  year  by  the  company. 

As  will  be  seen  from  this  table,  I  have  assumed  that 
the  sales  of  gas  by  this  company  can  be  increased  from 
2,000,000  M  cubic  feet  in  191 5  to  more  than  5,000,000 
M  in  1925. 

Accompanying  this  increase  in  sales  will,  of  course, 
be  a  very  material  increase  in  the  property  of  the  com- 
pany and  consequently  in  its  rate-making  value,  al- 
though such  increase  in  rate-making  value  usually  will 
be  proportionately  less  than  the  increase  in  sales. 

It  is  further  assumed  that  throughout  this  period  the 
company  finds  itself  able  to  make  such  modifications 
of  its  gas  rate  schedule  as  will  result  in  a  reduction  of 
i>£c  per  M,  each  year  in  the  average  selling  price  of 
gas,  and  that  the  company  also  will  be  able,  in  this 
period  and  with  the  sales  indicated,  to  reduce  its  operat- 
ing expenses  from  65c  in  191 5  to  47c  in  1925. 


It  is  understood,  of  course,  that  the  uniform  rates  of 
increase  and  decrease  here  shown  are  not  realized  in 
practice,  and  that  they  are  used  here  merely  to  illustrate 
the  method  of  this  calculation.  As  a  matter  of  fact, 
such  attractive  decrease  in  operating  expense  as  here 
indicated  could  be  brought  about  only  in  a  property 
showing  constant  gains  in  number  of  consumers  per 
mile  of  main,  gas  sold  per  meter,  etc.,  etc. 

Referring  now  to  the  year  1916,  it  will  be  seen  that 
the  gas  sales  for  that  year  are  shown  to  be  10%  in  excess 
of  the  sales  for  191 5,  that  the  average  net  revenue  per 
thousand  cubic  feet  sold  for  that  year  is  98J/2C,  and  that 
the  operating  expense  has  been  reduced  to  an  average 
of  63.2c. 

Such  operating  conditions  would  result  in  leaving 
35.3c  per  thousand  cubic  feet  sold,  or  $776,600 
available  for  bond  interest  and  dividends;  but  this 
amount  of  money  represents  6.81%  on  the  average 
rate-making  value  for  the  year  and  is  $14,676  more 
than  would  be  allowed  if  the  6.69%  rate  of  return  had 
been  maintained. 

It  therefore  becomes  necessary  to  show  that  the 
company  has  actually  saved  to  the  community  a  sum 
in  excess  of  this  $14,676,  which  I  claim  should  now  be 
allowed  in  addition  to  6.69%  return  on  the  then  rate- 
making  value. 

During  the  year  1916  an  increase  in  sales  of  200,000 
M  cubic  feet  is  shown.  It  is  possible  that  a  portion  of 
this  increase  might  be  traced  directly  to  the  reduction 


of  i^c  per  thousand  in  the  average  selling  price,  but 
as  the  percentage  will  be  difficult  if  not  impossible  to 
determine,  that  portion  of  the  saving  to  the  com- 
munity is  ignored;  but  it  is  very  clear  that  the  equiva- 
lent of  those  consumers  who  used  2,000,000  M  cubic 
feet  in  191 5  at  $1  per  thousand,  have  used  in  1916 
the  same  quantity  at  i>£c  less  per  thousand  cubic  feet. 

The  minimum  actual  saving  to  the  community 
through  this  reduction  in  the  price  of  gas  for  the  year 
1916,  will  therefore  have  been  $30,000. 

This  actual  saving  to  the  community  in  the  sum  of 
$30,000,  then,  is  the  measure  of  the  increase  in  net 
earnings  which  the  company  should  be  allowed  (if  able 
to  earn  it)  over  the  6.69%  determined  as  a  fair  rate  of 
return  under  the  conditions  of  191 5. 

For  each  of  the  years  the  calculation  is  carried  for- 
ward in  this  same  manner. 

For  example,  in  1917  the  savings  on  increase  in  sales 
during  that  year  are  ignored,  but  the  sales  during  191 5 
are  carried  forward  at  a  saving  of  3c  per  M,  and  the 
increase  in  sales  during  1916  are  carried  forward  at  a 
saving  of  ij^c  per  thousand  sold,  for  the  average  net 
revenue  of  191 7  is  shown  as  97c  per  M. 

These  cumulative  savings  for  191 7  aggregate  $63,000 
and  this  is  the  sum  which  should  represent  (for  the 
year  1917)  the  maximum  increase  in  earnings  allow- 
able to  the  company  in  excess  of  the  6.69%  established 
in  1915. 


It  will  be  noted  that  under  the  conditions  here 
assumed  the  actual  net  earnings  of  the  company,  in 
excess  of  the  6.69%,  would  not  exceed  the  minimum 
actual  saving  to  the  community  through  the  several 
reductions  in  the  price  of  gas  until  the  year  1925. 

When  such  a  condition  has  been  reached,  it  may  be 
that  there  should  be  made  for  the  following  year  a 
relatively  greater  reduction  in  the  average  selling  price, 
if  the  operating  expenses  per  M  of  1925  can  be  main- 
tained or  reduced. 

This  method  of  determining  rate  of  return,  while 
bringing  about  important  savings  to  the  community, 
would  offer  to  the  company  a  continuous  inducement 
to  the  increasing  of  its  sales,  the  reduction  of  its  oper- 
ating expense  and  the  reduction  of  the  average  selling 
price  of  gas. 

To  all  intents  and  purposes,  it  would  make  the  gas 
consumers  preferred  share-holders  in  the  gas  company. 

It  would  also  bring  about  savings  to  the  community 
constantly  increasing  not  only  in  the  total  amount,  but 
also  in  the  percentage  that  such  amount  bears  to  the 
total  paid  by  the  community  for  gas. 

For  example,  the  minimum  actual  saving  to  the 
community,  through  the  reduction  in  price,  in  1916 
would  represent  a  saving  of  1.38%  of  the  total  amount 
paid  by  the  community  for  gas,  whereas  in  1925  the 
minimum  actual  saving  to  the  community  would  repre- 
sent 10.84%  °f  tne  corresponding  total;  in  the  mean- 
time the  net  earnings  of  the  company  would  have  in- 


creased  at  a  slower  rate — viz.,  from  6.69%  in  191 5  to 
8.90%  in  1925. 

There  is  no  intention  that  the  figures  here  shown 
shall  be  considered  applicable  as  they  stand  to  any 
given  community  or  utility,  but  the  method  indicated 
in  this  calculation  can  be  applied  to  any  utility  in  any 
community. 

It  is  an  established  fact  that  the  flow  of  capital  into 
the  public  utilities  has,  since  the  coming  of  public 
utility  commissions,  been  seriously  retarded. 

The  writer  knows  personally  of  utilities  which  have 
been  prevented  from  coming  into  being  only  by  the 
fixed  rates  of  return  already  established  by  commissions 
in  connection  with  existing  utilities. 

It  must  be  borne  in  mind  that  the  final  judge  of  the 
sufficiency  of  any  rate  of  return  is  not  the  community, 
nor  the  commission — it  is  the  man  whose  money  is  to  be 
used. 

The  argument  of  the  existing  companies  in  hearings 
before  commissions,  has  been  directed  toward  securing 
an  increase  in  the  fixed  rate  of  return  thought  proper  by 
the  commissions. 

While  an  increase  in  the  fixed  rate  of  return  would 
doubtless  be  of  some  advantage,  through  providing 
some  further  incentive,  it  still  seems  clear  that  a  vari- 
able rate  of  return,  determined  by  the  efficiency  of  the 
utility  from  the  standpoint  of  the  community,  will 
prove  of  much  greater  and  more  certain  value  to  the 


community  than  any  fixed  rate  of  return  can  be  ex- 
pected to  prove. 

With  a  variable  rate  of  return,  such  as  here  sug- 
gested, the  community  would  be  assured  that  every 
effort  of  those  responsible  for  the  conduct  of  the  utility 
would,  at  all  times,  be  bent  toward  securing  greater 
sales  and  greater  efficiency  in  operation  and  a  lower 
average  price  of  its  product;  for  the  increase  in  volume 
of  sales,  in  connection  with  the  reduction  in  average 
selling  price  of  the  product,  would  determine  the 
amount  which  the  company  would  be  allowed  to  earn  in 
addition  to  the  fixed  percentage  determined  at  the  time 
of  original  hearing. 

Operation  under  such  a  plan  would  encourage  the 
establishment  of  new  utilities  in  communities  not  now 
supplied  and  would  cause  existing  utilities  to  be  of 
vastly  greater  assistance  in  the  building  up  and  general 
growth  of  communities  served. 


UNIVERSITY  OF  CALIFORNIA  LIBRARY 


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STAMPED  BELOW 

JUL  19  t91S 

MAR  9  W25 

V* 


■W/27  1929 


30m-l,'15 


icn< 


